Transfer pricing strategy and earnings informativeness

Abstract

While transfer price affects the allocation of profit among subunits of an organization and the information contained in earnings, little is known about how it affects investors' pricing of stocks. Research evidence on transfer pricing is rather limited due to lack of data, which is proprietary in nature. With reference to the arm's length principle under the tax regulations, this paper empirically explores the association between a firm's transfer pricing strategy and earnings informativeness, i.e., the degree to which information contained in earnings is reflected in stock price. Using data on related party transactions and controlling for firm characteristics, the results show that abnormal transfer price is negatively associated with earnings informativeness and earnings persistence. Additionally, firms with higher abnormal transfer price have greater discretionary accruals. The evidence suggests that managers manipulate transfer price through accrual earnings management, which reduces earnings informativeness and persistence, and that the enhancement of the tax regulations in transfer pricing contributes a decline in the informativeness of earnings. Our findings provide policy implication with respect to the tax regulations on transfer pricing.